Most investors are bewildered by the fact that interest rates on the 10 year U.S. Treasury have been going down year to date from 3% to 2.5% after rising from about 1.6% to 3% last year. At the end of last year virtually everyone expected interest rates to rise this year while the Fed tapered their purchases and the economy improved. In fact, the surveys taken by CNBC showed that every single economist predicted higher interest rates this year. Whenever you get a consensus so strong in these liquid markets you will find that they almost never pan out, and the masses going along with this crowd get fooled.

We believe that this consensus of people who believed that interest rates would rise will now agree falsely as to why the 10 year Treasury declined. Everyone seems to try to explain the move down as either a weaker economy or a “short squeeze.” We have been calling for a decline in interest rates for some time due to the world-wide deflation which we have been discussing in our comments for years. There is not much difference in the debt levels, especially in the financial sector, between the U.S. and Japan back in 1989. That was when Japan fell into the “deflation trap” (or “liquidity trap” explained later) that lasted for the past 25 years. We have used the “Cycle of Deflation” (first attachment) since the early 2000s and it couldn’t be clearer to us that this is the most likely scenario for the United States.

Last week the financial television shows interviewed numerous extremely sharp economists who all were concerned about inflation being the main problem this country will surely have to deal with over the next few months and years. One of them showed a chart of inflation being 1.1% at this time last year, 1.5% at the end of last year (2013) and 2% presently. He believed that this trend would continue moderately higher over the next few months and accelerate from there over the next few years. He did not think it would be horrible hyper-inflation, but one that would need the Fed to deal with the rising prices. He also believed that Ben Bernanke was not as concerned about inflation as he should have been when he was the head of the Fed. Another economist stated that, “at a minimum deflation is dead.” He was concerned about the rising prices of food, energy, and rents. He also believed that wages are a lagging indicator and with four months in a row of rising non-farm employment greater than 200,000 (he assumed that May would also exceed 200,000) wages would rise much more than they did in the past and since wages represent 40% of the core CPI index.

The other economists added more concerns to the above bringing up the fact that the cost savings for prescription drugs is now over, and the prices of cars and clothing are now rising. Global wages should rise from 2.5% to 3.5-4% as other central banks like the ECB and the Peoples Bank of China will be following us and the Japanese in easing as their economies slow down. Inflation rates are on the rise and the Fed is “behind the curve.”These economists that I referred to above are very sharp and present a powerful case for an inflationary scenario not only in this country but globally. We, on the other hand, strongly believe that this onerous debt that was generated from the early 1980s to present will more than likely end with the debt collapsing into a deflationary depression or another “great recession” both here and abroad. We would put a probability of around 60% on a deflationary outcome, but we also agree that if it doesn’t end in deflation, the next highest probability would be hyper-inflation and we would put about a 25% probability on that (with a 15% probability of muddling through with the debt continuing to expand for years).

VELOCITY OF MONEY

Our problem with the inflationary scenario is the velocity of money and multiplier of money. As far as velocity goes, the turnover of our money supply has been declining since the middle of the 1990s from 2.2 velocity to 1.5 now, and as it continues to decline we will not experience the recovery strength we witnessed after every downturn since the “great depression” (see 2nd attachment). The M1 Velocity (GDP/M1-see attachments #3--# 4) has declined from 10.5 in 2007 to 6.3 presently). When the consumer is overburdened by debt he or she is afraid to continue borrowing and spending, and most banks are reluctant to loan money to anyone except the most credit worthy. Under this scenario the velocity will continue declining producing a lower than normal money supply and GDP. The consumer debt relative to GDP jumped from a long term average of less than 50% for decades leading up to the middle of the 1980s where it grew to over 95% in 2008. We are now at 77% on the way back to the past 50% norm (see attachment # 5). In a similar attachment # 6, consumer debt to Personal Disposable Income (PDI) was under 60% for the decades of 1950 to the middle 1980s to almost 130% of PDI before the “great recession” starting in 2007. After peaking in 2007 the H/H debt to PDI has declined to about 105% presently on the way back to the norm of 60%.

MONEY MULTIPLIER

Another reason we are putting such a high probability of deflation (60%) versus inflation (25%) and muddling through (15%) is because of the money multiplier which determines how much the money supply grows relative to the monetary base. You see, the Fed can only control the Monetary Base and the Federal Reserve’s balance sheet. The Fed balance sheet grew from $800 bn. in 2008 to $4.1 tn. now, and most inflationists believe that unwinding that much money will create hyper-inflation (see attachment # 7). The Fed uses their tools of lowering the Federal Funds rate (the rate that the banks can borrow money from the Fed) and purchases of government bonds as well as mortgage backed securities (or Quantitative Easing --QE). They can also issue low cost Certificates of Deposit –CDs to the banks as well as reverse repos, but the main tools of the Fed are lowering rates and QE. However, these tools don’t directly control the Money Supply (MS). How much M2 grows is dependent upon the money multiplier and if it continues down as it has lately (see attachment # 8) the money supply will continue to be hampered by this multiplier.

“LIQUIDITY TRAP”

Another problem with the inflationary scenario is the “liquidity trap” we are struggling to escape from presently. This is a situation in which prevailing interest rates are low and savings rates are high, making monetary policy ineffective. In a liquidity trap, consumers choose to avoid bonds and keep their funds in the safest investments because of the prevailing belief that interest rates will soon rise. Because bond prices have an inverse relationship to interest rates, many consumers do not want to hold an asset with a price that is expected to decline.

In this situation, banks sell their bonds to the Fed and receive cash, but instead of loaning the dollars out they deposit the money back with the Fed as excess reserves and therefore the dollars do not recycle or circulate. This prevents the money supply from growing, and eventually has a deflationary outcome. You can supply all the money the Fed wants by increasing the Monetary Base, but if the public and corporations don’t want to borrow the money, the money supply is restricted and when you think there will be inflation, instead there will be disinflation and possibly deflation.

So, it seems to us that because of the velocity of money, the money multiplier, and the liquidity trap, inflation will be postponed indefinitely and replaced by disinflation or even deflation. The global environment for inflation is also on the side of disinflation as the European Union just reported an inflation rate of only 0.5% and Germany’s inflation rate was only 0.6%. The ECB will attempt to address these deflationary indicators this week (please see last attachment). And if China’s GDP growth continues on the downward growth path they could lead the way to emerging market weakness and disinflation or deflation.